Canadian and U.S. Reporting and Withholding Obligations—Independent Contractors
by Sonia Draper and James Samuel, KPMG LLP, Calgary
(KPMG in Canada is a KPMG International member firm)

The challenge of recruiting temporary workers for foreign assignments is not an easy one for most employers. One solution that provides employers and employees with benefits and flexibility is to engage independent contractors. With the application of the North American Free Trade Agreement (NAFTA), recruiting professionals from across the Canada-U.S. border for project assignments is becoming more commonplace.

Engaging independent contractors is not altogether straightforward, however. In addition to ensuring that the relationship between the company and the contractor is not considered to be that of an employee-employer, a company must also consider the reporting and withholding implications for cross-border assignments. Canada and the United States both have comprehensive criteria in place for determining whether an employee-employer relationship exists. This article discusses the reporting and withholding obligations in respect of payments for services made to an independent contractor who is an individual, rather than a corporation owned by the contractor.

The Treaty

Article XIV of the Canada–U.S. Income Tax Convention ("the Treaty") provides an exemption from U.S. tax for Canadian resident independent contractors providing independent personal services in the U.S. if the contractor does not have a "fixed place of business regularly available to him" in the U.S. (similar provisions apply in the reverse case, for a U.S. resident contractor providing services in Canada). In general, a fixed place of business is considered to be a place of business which is controlled by and identified with the independent contractor carrying on business.

In both countries, a contractor's residency status will determine the appropriate form of withholding and reporting. Each country has its own rules for establishing residency, but in cases where tax residence ties exist in both Canada and the United States, the Treaty may be used to establish residency. The Treaty provides that the following criteria be examined, and in this particular order, in determining the tax residence of a taxpayer:

  1. location of the individual's permanent home;
  2. location of the individual's personal and economic interests (i.e., center of vital interest);
  3. location of the individual's habitual abode; and
  4. citizenship of the individual.
If residency is still not determinable under the Treaty, competent authority from both countries will make an agreed upon determination.

Canadian Reporting and Withholding Obligations

Payments to Nonresidents of Canada
Every person that makes payments to a nonresident of Canada for services provided in Canada must withhold and remit an amount in accordance with the Canadian Income Tax Act. Where the recipient of the payments is an independent contractor and not an employee of the payor, a withholding tax equal to 15 percent of the gross amount paid to nonresident individuals for services rendered in Canada must be withheld.

This withholding requirement only applies to services performed within Canada by a nonresident of Canada. The requirement to withhold can be avoided if the nonresident contractor obtains a waiver of withholding tax from the Canada Customs and Revenue Agency (the CCRA). This waiver is available in situations where the nonresident can demonstrate that the withholding is more than his or her Canadian tax liability, because of Treaty protection or his or her estimated income and expenses. However, a "treaty-based" waiver will only be granted if the contractor does not have a fixed place of business in Canada and meets other restrictive criteria.

If the individual has not obtained written notification from the CCRA, withholding at 15 percent is mandatory. Failure to deduct or remit the withholding tax may result in the payor being liable for the tax owing, as well as interest and penalties.

Payors are required to remit any tax withheld by the 15th day of the month following the month in which the amounts were deducted or withheld.

All payments made to nonresidents for services provided in Canada, regardless of the amount paid or taxes withheld, must be reported to the CCRA. This information should be reported on a T4A-NR Supplementary slip and forwarded to the CCRA on or before the last day of February of the year following the year in which the income was paid. A T4A-NR Summary, summarizing all payments made to nonresidents during the taxation year for services rendered, must also be sent to the CCRA by the same deadline. A copy of the T4A-NR slip should also be sent to the recipients for their records.

It is important to note that the withholding tax is not the final tax to the contractor. The Canadian withholding tax is merely an advance payment of his or her ultimate liability. Any Canadian tax withheld by the payor in respect of services rendered by a nonresident will be treated as an installment against Canadian tax liability on the Canadian income tax return. Because a nonresident contractor (with no fixed base in Canada) will generally be exempt from Canadian income tax, he or she will only be required to file a Canadian nonresident income tax return to obtain a refund if tax is withheld.

Payments to Residents of Canada
Residents of Canada, whether or not they are considered employees or independent contractors, are subject to tax in Canada on their worldwide income. As a result, any payment for services made to a resident of Canada is subject to Canadian income tax.

A company is not required to withhold or remit any income tax for payments made to independent contractors who are resident in Canada. Instead, independent contractors are responsible for remitting tax installments throughout the year and filing a Canadian income tax return. Therefore, no withholding, remittance, or reporting requirements exist for payments for services made to contractors who are resident in Canada.

U.S. Federal Reporting and Withholding Obligations

The U.S. reporting and withholding requirements of the payor will depend on whether or not the payor is making a payment for services to nonresident aliens (i.e., individuals who are not U.S. citizens, green card holders, or tax residents) or U.S. individuals. Failure to properly report and withhold tax on payments made to nonresident aliens or U.S. individuals may result in significant penalties (and/or the tax liability if not ultimately paid by the contractor) to the payor. For reporting and withholding purposes, the nonresident independent contractor will need to apply for a U.S. taxpayer identification number (TIN) by completing Form W-7, Application for IRS Individual Taxpayer Identification Number, and filing it with the Internal Revenue Service (IRS).

Payments Made to Nonresident Aliens of the U.S.
In general, absent a treaty which may provide for a reduced rate of withholding, payors are required to withhold U.S. tax of 30 percent on the gross amount of a payment to a nonresident alien in respect of services provided in the United States. If, in advance of payment, a contractor does not provide the payor with appropriate documentation that allows the payor to determine whether the contractor is a U.S. person or a nonresident alien, the payor should presume it is making a payment to a U.S. person, and without a TIN, the payor must withhold tax at a back-up withholding rate of 31 percent (30.5 percent for payments made after August 6, 2001). Furthermore, the domestic reporting requirements described below for payments made to U.S. individuals will apply.

A nonresident alien (who does not have a fixed place of business in the U.S.) may claim exemption from U.S. withholding by completing Form 8233, Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual. If the contractor is eligible for exemption from withholding tax under the Treaty, the contractor should provide a completed Form 8233 to the payor prior to receiving the first payment.

Payors are required to file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, with the IRS. A copy of Form 1042-S must also be provided to the person from whom the services were received. Forms 1042 and 1042-S, generally, must be filed with the IRS on or before March 15 of the year following the year of the payment. The date by which the payor will be required to remit any tax withheld is based on the total amount of tax (i.e., total withholdings on payments to foreign persons) the payor has withheld.

For additional information on U.S. withholding and reporting for personal services, see Larry Ghirardo, "Payroll Withholding and Reporting for Foreign Nationals in the US—Effect of Income Tax Treaties," The Expatriate Administrator, Issue No. 2001-2, Summer 2001.

Payments Made to U.S. Individuals
In general, if in the course of business, a payor makes a payment of more than USD 600, in a calendar year to an independent contractor who is a U.S. individual (i.e., a U.S. citizen, green card holder, or tax resident) in respect of services performed, the payor is required to report such payment to the IRS on Form 1096, Annual Summary and Transmittal of U.S. Information Returns, and Form 1099-MISC, Miscellaneous Income. A copy of Form 1099-MISC must also be provided to the person from whom the services were received. Forms 1096 and 1099 must generally be filed on or before February 28 of the year following the year of the payment.

In order to complete Forms 1096 and 1099, the payor will need to obtain the name, address, and TIN from the U.S. person to whom the payment for services is made. This information may be obtained by having the contractor provide a completed Form W-9, Request for Taxpayer Identification Number and Certification. Although a payor is generally not required to withhold tax on payments to independent contractors, in certain circumstances, the payor may be required to deduct and withhold 31 percent of the payment made to a U.S. person (30.5 percent for payments made after August 6, 2001). This "back-up withholding" may be required, for example, if the contractor fails to furnish his or her TIN on a completed Form W-9, or if the IRS notifies the payor that the TIN furnished by the payee is incorrect.

Resident and nonresident independent contractors are required to file the appropriate U.S. income tax return. Any tax withheld by the payor in respect of services rendered by a nonresident should be treated as an installment against the nonresident alien's U.S. tax liability on his or her U.S. income tax return. Contractors that are not subject to U.S. tax must file a U.S. income tax return including a treaty-based return disclosure which is a statement that indicates that he or she is not subject to U.S. tax by virtue of the Treaty.

Conclusion

Although engaging independent contractors may represent a potential solution to the challenge of recruiting temporary workers for foreign assignments, doing so may give rise to complex taxation and reporting issues for a company. Not only must a company ensure that the relationship between it and the contractor is not considered to be that of an employee/employer, the company must also consider the reporting and withholding implications for cross-border assignments.

In many circumstances, the reporting and withholding requirements for the company (i.e., the payor) can generally be determined under the rules described above. Where applicable, it is essential that the company receive the appropriate documentation from the contractor before making the first payment to the contractor in order to help minimize the company's exposure to withholding tax issues.

Similarly, cross-border assignments may also give rise to complex taxation and reporting issues for the independent contractor. In particular, the interaction and interpretation of residency and tax status under the domestic laws of each country, in addition to the application of the various applicable Treaty articles, can add layers of complexity to the independent contractor's tax compliance.

If engaging an independent contractor appears a viable solution to a company's recruitment woes, the company should first consult a professional tax adviser to consider all the ramifications and help ensure compliance with the rules.

© 2001 KPMG LLP, the United States' member firm of KPMG International, a Swiss association. All rights reserved.